Activist Short Selling Today: The Two Sides of the Coin

Two extraordinary accounting scandals — one at Luckin Coffee Inc. in China and the other at Wirecard AG, the German digital payments firm — have revealed brazen and bankrupting frauds, directed by the most senior executives at each firm. Together, they tend to support three conclusions:

  • Stealing candy from a baby appears to be harder than getting fraudulent financial statements past a Big 4 accounting firm;
  • If you want to detect fraud, forget the accountants and contact your local short sellers; they are the real detectives today; and
  • When the fraud is really egregious, we often find that the regulator has been captured by the fraudster.

Indeed, in Germany, the securities regulator sought to bar short selling in Wirecard and actually launched criminal complaints against two Financial Times journalists for stock manipulation because they had interviewed the short sellers.[1] In the end, BaFin (the German regulator) succeeded only in shooting itself in the foot.

Reform is probably coming in both countries, but will it be the right reform? If all that is done is to deny accounting firms the ability to engage in outside consulting for their audit clients, little will have been achieved.[2] This column cannot cover everything in these scandals, so it will focus on the short sellers. Here, we face a paradox: Sometimes, they are the hero of the story, and sometimes the villain.

On the positive side, they uncovered the frauds at Luckin Coffee and Wirecard, and in the recent past, they shined the spotlight of disclosure on Valeant Pharmaceuticals. James Chanos deservedly became the patron saint of short sellers for his long and risky efforts to organize the campaign that ultimately brought down Enron.

But, on the other side of the ledger, we have the new “short and distort” literature, which focuses on “pseudonymous” short selling that leads to serious mispricing of securities.[3] Academics also divide between those who see the short seller as the “Gatekeeper of the Efficient Market” and those who see predatory and opportunistic behavior increasing.

Thus, controversy is likely over the question of how we should regulate short sellers — particularly in a pandemic when market volatility soars. Last week, this author participated in a virtual debate at the Swedish House of Finance in Stockholm on the regulation of short selling.[4] For the most part, the economists wanted little regulation, but, characteristically bucking the trend, this author argued for some and suggested his preferred policy levers.

The pattern that most justifies greater regulation is that exhibited by many “pseudonymous” sellers that sell short, publish a lengthy, detailed, and plausible attack on the target company, but then close their short positions shortly thereafter (without disclosure), sometimes even going long in the stock to profit on any later rebound in the stock price when management replies. To illustrate, suppose I have acquired a reputation as a cagy, astute short seller, using the nom de plume “Sherlock Holmes.” After taking a short position in XYZ, Inc., I publish a detailed attack on the company’s accounting under the headline “Worse than Enron.”[5] This attack is published on Monday, and XYZ’s stock price falls 25% from $10 per share to $7.50 per share (with over 100 million shares trading on that date). I close out my short position on Tuesday, profiting handsomely. On Wednesday, the company replies with a detailed report, and the market price rebounds to $10 per share. The company took two days in order to check with their accountants and leading experts and to make certain that they had made no misstatement that would trigger the SEC’s attention. All told, some 200 million shares traded over this interval at prices below $10.

Consider one further variant on this scenario: Our short seller not only closed his short position on Tuesday, but actually went long, seemingly expecting that the market price would rebound when the company replied. Now our short seller looks less like a hero, and more like a predator, as retail investors have been induced to sell below the $10 price (which remains stable for the rest of the quarter).

A key feature in this pattern is the use of the pseudonym because it allows our short seller to avoid permanent reputational loss. After this debate, the reputation of “Sherlock Holmes” will be negligible in the short selling world, but our trader can simply switch to a new name, say “Sam Spade,” and gradually build up a new reputation for that new name. To be sure, our trader will have to make some astute calls under this new name, but if he does, he is back in business — and he can profit even when retail shareholders lose because he closes his position quickly. Even in an efficient market, plausible misinformation will drive the target’s stock price down, and our trader can profit both on the fall and subsequent rise in the stock price.

So what can be done about this? In another country, one answer might be to preclude anonymous attacks by short sellers and other analysts. But in the U.S., our First Amendment protects anonymous speech, and any contrary SEC rule would be clearly unconstitutional.

My colleague, Professor Joshua Mitts, has made a logical proposal: The SEC should impose minimum holding periods, so that the short seller could not profit if the stock went down for one or two days and then reverted to its original price once the company responded. This is directly addressed to this V-shaped pattern of decline and reversion, which does suggest an intent to manipulate. But the SEC probably lacks the authority to impose such a prophylactic rule (without legislation).

My own answer starts from a preference for using the least drastic means and the recognition that the SEC only has authority, as a practical matter, to adopt antifraud rules. Thus, in a recent petition to the SEC that Professor Mitts and I largely drafted (and a fair number of luminaries signed), we urged the SEC to adopt a prompt disclosure rule that would require immediate disclosure when the short seller hedged or closed out his short position.[6] Such a rule could also rely on “scalping theory” — a fraud doctrine that has been applied to newspaper columnists who recommend a stock with the unstated intent of immediately closing their position after a modest price runup caused by their recommendation.[7]

One other proposal is consistent with my preference for the least restrictive alternative. Today, we have an individual stock “circuit breaker” rule: If the stock declines 10% or more in a day, short selling must cease for the day (although the short seller can again sell short the next day — at least until the 10% level is again hit). Such a rule allows the short seller to profit, but not to turn a decline into a rout.

Such a rule could be modified. The point at which the circuit breaker would kick in could be related to the level of volatility in the market. Either one could look to a volatility index, or the SEC could decide, in light of the pandemic, to reduce the circuit breaker level from 10% to 8% for a 90-day period. This is far less drastic than the SEC’s response in 2008 when it banned all short selling in specified financial industry stocks.

One last thought merits consideration: The case for short selling and the justifications for its restrictive regulation should depend on, and be related to, the level of transparency in the market. Muddy Waters, the most successful contemporary short seller, operates primarily in China. Although founded by Americans, the firm’s name comes not from the famous American blues singer, but from a Chinese proverb: “You catch the most fish in muddy waters.” China remains a uniquely opaque market — a Wild West of fraudsters and misinformation. Muddy Waters’ role is thus vital, because China has committed less in the way of enforcement resources (public and private) to combat securities fraud. In contrast, the U.S. market is more transparent and is guarded by other protections (criminal prosecutions for securities fraud, securities class actions, some reputable securities analysts, and possibly somewhere an honest auditor). In a more transparent market, the short seller is less indispensable and can appropriately be subjected to marginally tighter regulation.

In the last analysis, short sellers are like vultures. Both are vital to the environment, but more so in environments populated by “walking zombies” — hopelessly insolvent companies like Luckin Coffee and Wirecard that have refused to admit that they are dead. In all markets, however, we need to encourage them to feast only on truly dead carcasses.


[1] For concise summaries, see Katherine Griffiths, “Pressure Rises on Regulator and EY on Wirecard’s Fall,” The Times (London) June 27, 2020; Chris M. Spencer, “Wirecard: The Biggest Accounting Fraud? Is the Customer Money Safe?” The Financier, June 28, 2020. Most commentators are already speculating as to whether the Wirecard/EY relationship will parallel the downward spiral of Enron and Arthur Andersen.

[2] For a more realistic appraisal of how to make auditors behave honestly, See John C. Coffee, Jr. “Why Do Auditors Fail? What Might Work? What Won’t? (2019) (arguing that only a greater role for shareholders in the auditor selection process could work). In effect, we face a principal/agent problem, which cannot be solved by allowing managers to pick their monitor.

[3] Here, the work of my colleague, Professor Joshua Mitts, stands out. See Joshua Mitts, “Short and Distort,” Professor Mitts identifies some 1720 pseudonymous short campaigns against mid-size or large companies between 2010-2017 and finds over $28.1 billion in mispricing.

[4] The Swedish House of Finance is Sweden’s national research center in financial economics. The Program on June 30, 2020 was titled: “To Ban, to Restrict, or to Leave Alone: Short Sales in the 2020’s.”

[5] This was the caption used by Harry Markopolos in his short campaign against General Electric in 2019. In that year, Mr. Markopolos attacked GE’s accounting and earnings, publishing a report for which he was compensated by short sellers based on a percentage of their profits. Initially, his report drove the stock price of GE down by over 20%, but that price soon rebounded to its original level, while over 400 million shares traded on the date his report was published. The point here is only that short seller attacks can seemingly win at the outset and then fail over a longer period.

[6] See John C. Coffee, et al, “Petition for Rulemaking on Short and Distort,” (2020).

[7] See, e.g., Zweig v. Hearst Corp., 594 F.2d 1261 (9th Cir. 1979).

This post comes to us from John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.

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